After years of rapid expansion, exchange-traded funds, or ETFs, have slowed in growth as the economy declines. Indeed, many ETFs that tracked more exotic indexes have been closed and unwound, while others languish with little or no trades.

But product providers are fighting back with issues designed for the current bear market, such as leveraged and inverse ETFs offered by ProShares or more recently, Direxion. And investors are showing interest in new fixed-income ETFs such as pre-refunded muni bonds, high-yield muni bonds, high-yield taxable bonds, international bonds and emerging- market bonds.

There has been a significant expansion in ETF bond products of late. From mid-2008 until early this year, muni-bond ETFs, like iShares S&P National Muni Bond Fund or PowerShares Insured National Muni Bond Fund, were popular, but in the current economic downturn, experts are cautioning investors about the credit risk of municipal and other tax-advantaged issues.

Morningstar ETF analyst Scott Burns says investors have to watch out for muni index ETFs, "particularly the bigger ones, like California or Arizona bonds, where the credit risk is greatest." These ETFs are more useful for speculative trading purposes than as anchors in a portfolio.

Caveats also apply to most of the other new ETFs in the fixed-income space, which until last year was limited to Treasury ETFs, says Greg Maddox, director of manager research for the Private Banking and Wealth Group at Wells Fargo Bank. iShares' Barclays Euro Corporate Bond ETF or State Street's SPDR Barclays Capital Mortgage Backed Bond ETF have credit and interest-rate risks that need to be clearly explained to clients. So too with high-yield munis, high-yield taxable bonds and emerging-market bonds.

One exception: Pre-refunded municipal bonds, like the Van Eck Market Vectors Pre-Re Muni Index ETF launched in February. Pre-re muni bonds are fully backed by Treasury securities that a municipality buys and holds in escrow to cover the coupon payments and the principal at maturity. Last year, pre-refunded munis returned 6.5%, compared with a 2.5% drop in the overall muni market. Market Vector's Pre-Re Muni ETF showed a market return of 0.45% and an NAV return of 1.15% for March, the issue's first full month on the market.

 

BEAR MARKET SPECIALS

The bear market also has investors curious about commodity ETFs and newer leveraged and short commodities ETFs, like the ProFunds leveraged and short gold and silver ETFs launched last December. "Economists say the stimulus program will likely create an inflationary environment, and people want protection against that, hence the interest in commodity ETFs," says Burns. Gold ETFs have been popular as concerns grow about the dollar.

With some 24 commodity ETFs already trading in 2008, new ones, for example, like equity ETFs before them, are now offering the opportunity to leverage or short commodity indexes.

Inverse ETFs, which allow the holder to win when the market loses, or even to double or triple a market decline are attracting interest. "People are using the inverse products to hedge the markets as they go down," says Maddox. "but there's a great deal of risk in inverse products. You can't just set 'em and forget 'em." These ETFs are reset every day.

In an article titled "Leveraged and Inverse ETFs Kill Portfolios," Paul Justice, a Morningstar ETF analyst, explains that these products, which amplify or inverse an index's performance, can only work for an investor who adjusts his portfolio every day. Because, he notes, in a volatile market that is down as often, and by as much, as it is up, daily compounding hurts more on the downside. For example, for 2008, the Ultrashort MSCI Emerging Markets ProShares ETF, which is supposed to double inverse the MSCI index, ended down 20% when the underlying index lost 52% for the year. Similarly, the UltraShort Oil & Gas ProShares ETF that double shorted the index was down 19%. Both products performed as designed on a daily basis, but over the course of a year, an investor who simply bought and held either product-double leveraged or double shorted-would have lost money.

Using a more basic product like ProShares Ultrashort S&P 500, which offers a double inverse tracking of the S&P 500 Index, says Michael Sapir, CEO of ProShares Advisors, will deliver an accurate double inverse of the performance of that index. "If you don't adjust your Ultrashort holdings, you can have the index down at the time as your Ultrashort ETF," says Sapir, who explains that resetting is easy. "Say you have $100 in the S&P and you want $200 of short exposure over time. If after two weeks you actually have $220 of short exposure because the index has gone up to 105, you would sell part of your inverse ETF holding to reduce it to $210." This tracking problem is less serious with some commodities ETFs, which only reset monthly, instead of daily, he says.

There are also a lot of new hedge products coming out that try to replicate the hedge bets of alternative instruments, adds Maddox, "only they are more liquid." Like the first such ETF, the IQ Hedge Multi-Strategy Tracker ETF launched in March, these are "very complex," he says, adding that for now we prefer the traditional hedge fund structure."

Maddox warns investors to stay away from exchange-traded notes (ETNs). While these were popular last year, ETNs are promissory notes, and thus a kind of derivative, rather than a bundle of actual stocks or bonds. Hence they "are a bit more problematic in this credit environment," says Maddox. Some issuers, he reports, are having trouble raising capital, "so we recommend avoiding them in the near term."

 

ETFs of ETFs

In general, the numbers suggest that even with investors leery about the financial markets, ETFs are gaining ground, particularly compared to mutual funds. In 2008, mutual funds lost close to $400 billion in invested assets, in addition to the capital depreciation they suffered in the market crash, according to Tom Lydon, editor of ETFtrends.com. Over the same period, ETFs had a net inflow of $178 billion in new assets, some of it new, and some of it shifting away from mutual funds.